Futures trading in traditional financial markets offers a basis for that in cryptocurrency markets. But key distinctions should be drawn — not least of all having to do with risk.
There are several investment options available to investors in the traditional financial markets, such as forwards, spot, and futures trading. Understanding exactly what these trading types look like and how they play out in different financial markets is key to achieving one’s investment goals.
This article focuses on futures trading. We will delve into what you need to know about futures trading in two contrasting markets. After reading, you should know what futures trading is and how it plays out in cryptocurrency versus traditional financial markets.
Futures Trading in Traditional Financial Markets
Futures trading is one of the advanced methods of trading in the financial markets, crypto or traditional. It involves trading derivative contracts that require both parties to complete a predetermined transaction at a set time and price in the future. These contracts are known as futures contracts.
A futures contract is a legally binding agreement between two parties to transact a commodity, security, or asset at a future date and price already predetermined in the contract. In essence, the purchasing party in this scenario is legally bound by the futures contract to buy a commodity, security, or asset at the expiration date of the futures contract. Likewise, the seller is bound by the same legal document to sell the item, asset or security when that contract expires.
A futures contract contains the following:
- Currency unit denomination for the contract
- The number of goods to be delivered
- Settlement option for the trade (including cash or physical delivery)
- The unit of measurement
- The grade or quality of goods when needed
For example, if one wants to sell 1,000 bars of gold at $750,000 in approximately a year, they can sign a futures contract with a potential buyer. This could be because they anticipate the price of gold being unstable at that time of sale. A futures contract ensures that they can sell off their gold bars at a current favorable price. With a futures contract, it doesn’t matter what the market price of a gold bar is in a year; the seller is assured of getting $750,000 per gold bar.
On the other hand, the buyer might incur a gain or loss from such a contract. This is hedging. If the price of gold increases to, say, $800,000 by the expiration date of the futures contract, they make a profit of $50,000 per gold bar. This is speculation. They could also incur a loss if the market price in a year goes down to $700,000.
However, it’s also crucial to note that the buyer can sell futures contracts anytime before the agreement’s expiration date.
Compared to spot trading and over-the-counter (OTC) trades, futures contracts are usually drawn up to a general standard to improve trading on a futures exchange. This standardization is vital because of the peculiarities of a futures contract. For instance, if someone wants to buy a futures contract for 10,000 bars of gold, they may have to buy 100 futures contracts for 10 bars of gold each.
There are many classes of futures contracts. They include:
- Currency futures
- Stock Index Futures
- Precious metals futures
- US Treasury Futures
Futures contracts are used for hedging and speculation.
Futures hedging: Futures can be used to hedge the price of the asset traded. Unlike speculation, hedging is a sure-fire way of ensuring that you don’t run into losses due to market price fluctuations. Most sellers use it to ensure they don’t make a loss on their commodity. In futures hedging, the main goal is to stave off a loss and not necessarily make a profit, although profits can be made.
Futures speculation: Futures speculation is different from hedging primarily due to its purpose. The goal of speculation in futures trading is to make a profit. The buyer of a futures contract can predict an increase in the underlying asset price and sell it at the new increased price to make a profit.
How to Trade Futures
Futures are traded via brokers and specific individuals who are registered at the futures markets. The first step is to get a stockbroker. Depending on your experience with such investments, you and your broker would determine what level of risk is comfortable for you.
Risk plays a significant role in the margins and positions you would take as you start trading. A risk level placed too high opens up the potential for hefty profits or heavy losses depending on how the market swings. After this step, you can begin trading on the types of futures contracts that interest you. Knowing the advantages as well as the disadvantages will be further helpful — below are a few.
Advantages of futures trading:
- Through speculation, traders can potentially make a nice profit on trading futures contracts.
- Businesses can hedge the prices of their commodities to prevent losses.
- Futures trading doesn’t require paying the total amount of the contract with your broker. Traders are required to pay a down deposit.
Disadvantages of futures trading:
- The risks of a loss are high because futures trading uses leverages.
- Companies that hedge can lose out on substantial profits as a result of favorable price changes.
- Leverages amplify profits as well as losses.
Futures Trading in Crypto Markets
Futures trading is one of the primary ways people trade in cryptocurrencies. In crypto, futures trading works on the same principle of drawing up a transactional contract between two parties due on a future date. The price of the cryptocurrency traded is pre-agreed and would not change despite any changes in the market. Nevertheless, both parties are expected to honor the contract and sell at the agreed price and date.
This is what makes futures trading such a gamble in cryptocurrency. Here’s a practical example: Trader A has two Bitcoins to sell, with one Bitcoin priced at $30,000. He signs a futures contract with Trader B, who would purchase the two Bitcoins at a later predetermined date one year later. In the 12 months, until this futures contract expires, the price of Bitcoin could either go up to $50,000 or go down to $20,000 per Bitcoin. In either case, in 12 months, Trader B would still acquire the 2 Bitcoins from Trader A at $30,000 per Bitcoin.
This is a basic example of futures trading in crypto. However, when margins and leverages come into play, futures trading in crypto becomes even riskier than it already is. A margin is the amount of money put into buying your position. Many futures trading contracts in crypto require an initial margin, which is a percentage of the contract’s total value. A high margin or leverage could spell a hefty profit or loss for the trader depending on how the market price rises or falls.
Futures trading in crypto can be very rewarding or very punishing. Before you venture into it, here are two factors to consider before futures trading in cryptocurrency:
Experience: Only experienced traders should trade futures in crypto because success requires timing. Having a good gauge of the market and knowing when there will be a potential rise in the value of cryptocurrencies requires experience. Any mistake in timing can mean the difference between a loss and a profit.
Risk: Every investment comes with risks, but futures trading in cryptocurrency comes with more than its fair share of troubles. However, the kicker here is that with its high risk comes a high chance of substantial profits.
Ultimately, futures trading is an investment method used in both crypto markets and traditional financial markets that can lead to steep profits as well as deep losses. In crypto markets, however, futures trading may be riskier than in traditional financial markets. As such, it would be the wiser to gain some experience under your belt before venturing into futures trading.
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